How High Will the Dow Go?

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That's the question asked in a NYT article this morning. Of course, the more important question is the path of the much broader S&P 500 index. The article notes that the price to earnings ratios here are not much higher than their historic average. But the key part of the story is the path of earnings going forward. Earnings are highly cyclical. They have risen very rapidly in the last three years and are now approximately the same share of income as they were at the peak year of the 90s cycle (1997). The earnings share typically falls substantially after peaks, implying stagnant or declining profits. Based on this pattern, the Congressional Budget Office projects that profits will actually be lower in nominal terms in 2011 than they are today (The Budget and Economic Outlook, Fiscal Years 2007-2016, Table 2-1). My crystal ball would support the declining profit view. We are just beginning to feel the effects of the collapsing housing bubble and it is not going to be pretty. It is also worth noting that productivity growth has slowed sharply in recent quarters. With the sharp upward revision to employment growth, productivity growth will be under 2.0 percent for the six quarters ending in the 3rd quarter of 2006 (assuming consensus projections for 3rd quarter GDP). If we ever see any wage growth in this cycle, it should be now and it will be at the expense of profits.

--Dean Baker

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